The government is preparing to write off almost £1bn of overpaid tax credits following a series of errors and fraudulent claims that have dogged the much-publicised benefit system in its first two years.

In a critical report, a powerful parliamentary watchdog said yesterday the level of errors and fraud in the tax credit system remained unacceptably high.

The National Audit Office refused to sign off the accounts of HM Revenue & Customs in respect of tax credits and said officials needed to put in place more sophisticated controls to cut back on the number of errors and fraud in the tax credit system.

The NAO said initial figures had underestimated the extent of the problem and total overpayments in 2003-04 had risen from £1.9bn to £2.2bn. The Revenue, which administers tax credits, estimates that overpayments for 2004-05 awards will also affect nearly two million families with an average overpayment of £1,000 each.

Ministers have already written off £123m of overpayments and will waive £961m in total after an assessment by officials found that it would be uneconomic to pursue much of the debt.

Responding to the report, Revenue & Customs said it would also show compassion in circumstances where overpayments were made to families on low incomes and would agree to write off repayments.

Anti-poverty groups and opposition MPs have criticised the Revenue for pursuing low income families receiving tax credits who could be pushed into debt if they are forced to hand back the money.

Last week it was revealed that tax credit helplines received more than 100m calls in the first two-and-a-half years of operation and more than half went unanswered. Child Poverty Action Group has threatened court action against the Revenue unless it revises procedures for reclaiming overpaid credits, saying it was pushing low income families below the poverty line. Despite assurances by the Revenue that it treats cases sensitively, complaints continue to clog CPAG and Citizens Advice helplines.

David Laws, a Liberal Democrat spokesman, said the report showed the tax credit system was getting worse. He pointed to figures showing the Revenue expects to spend several years recovering tax credits from each tax year, leading to a cumulative burden for officials given the job of recovering overpayments.

"These new figures show that the chaos in the tax credit system is worsening," Mr Laws said. "The previous level of overpayments for 2003-04 was huge, but now we find out that the final figure is even higher. And the admission that overpayments for 2004-05 could be at a similar level is particularly shocking when we were told the level to 2003-04 was expected to be considerably lower.

"The paymaster general must make an urgent statement on these figures. I am extremely concerned that the Treasury is in a state of denial over the bureaucratic chaos they have created."

Sir John Bourn, head of the NAO, said families moving from weekly benefit payments to making annual predictions of their future income represented "a significant cultural shift for many claimants" and making repayments had caused difficulty for many families. "Although there is some limited interim evidence that the level of claimant error and fraud involved in the payment of the new tax credits may have fallen, that level remained unacceptably high and therefore I have once again qualified my audit opinion on the Inland Revenue's trust statement," he said.

David Varney, chairman of Revenue & Customs, said the scale of the operation meant there would always be errors. He claimed a new management team was already tackling many of the issues pointed out in the report, but "some improvements would take longer to deliver than others".